Check out some examples to see how normal and standard costing are used for different reasons: to calculate costs after the fact when they're known vs. using the materials and labor that it should take to make a product to calculate costs.

The Production Process

Becky is the manager of a neighborhood bakery, and she produces delicious baked goods.

When we hear the word production, we normally think of heavy manufacturing, like building cars or making steel. But the same concepts used in any production also apply to a bakery. So let's look at the three cost components of Becky's baked goods. They are:

Direct materials: The cost of the ingredients, like the flour, icing and decorations that go into a finished baked good.

Direct labor: The cost of the employees' time to make the product.

Overhead: All of the other costs involved with running the bakery. That includes heat and air conditioning, janitorial and cleanup service, security and Becky's own salary!

Becky needs to know these costs in order to prepare her financial statements and plan for her business. She also needs to know the cost of everything she bakes so that she can charge a price that is competitive and also allows her to make a profit.

Normal Costing

Becky has been using normal costing when she prepares her financial statements. The formula for normal costing is:

So if Becky uses $200 worth of ingredients in a wedding cake and it took her bakers and decorators 7 labor hours to make it at a $20 per hour pay rate, she has two of the cost pieces covered. That leaves overhead. For that she uses a budgeted rate, which includes all of the overhead items for the year divided by a base; in this case, the number of labor hours budgeted for the year. The rate comes to $10 per labor hour, which can be added to any product's costs based on the number of labor hours it takes to make that product.

It is important to know what it cost to make this cake!

Now let's cost out that wedding cake using the formula:

Normal cost of wedding cake = $200 + (7 * $20) + (7 * $10) = $410. Becky knows that if she charges the couple $650 for that cake she will cover all three of her costs and make $240 profit!

Becky likes using normal costing because it is accurate as long as the budgeted overhead rate is good. But now that her business is expanding and growing, she needs another costing tool to help her with planning and managing her business.

Standard Costing

Normal costing works best after the fact, when you know the amounts of all of the costs that went into a product. But Becky is getting into the catering business now. She is excited because it is fun to work with couples who are planning a wedding. It is also a way to get her fabulous baked goods into the hands of the wedding guests who might turn into future customers!

She's looking for a way to be able to quickly estimate what her costs are going to be for a catered event so she can quote a price. What she needs is a standard cost for the items she bakes. That way, when a couple needs, say, 200 cookies for their wedding, Becky can quickly tell them what they will cost.

The standard cost of a wedding cake is what it ''should'' cost to bake and decorate the cake. Becky knows how much flour and how much flavoring goes into the cake. She knows what goes into the icing (it's secret!), and she knows how long it should take the baker to mix the ingredients and bake the layers. She also knows how many hours it should take her decorators to put the cake together, frost it and put the bride and groom on top.

Once she knows the labor hours involved, she can use the budgeted overhead rate and attach some of her overhead to the cake. The formula for standard costing is different for materials and labor, but the same for overhead as normal costing. It looks like this:

If a batch of 100 chocolate chip cookies should use $20 worth of ingredients, should take one hour to mix and bake at $20 per hour, and should have a budgeted overhead rate of $10 per labor hour, the standard cost of the cookies is $20 + (1 * $20) + (1 * $10) = $50.

Why Use Standard Costing?

Becky realizes that standard costing is a powerful tool. It allows her to quickly estimate her costs for any catered event and work with the customer on a final price. She can do this with confidence that her costs will be covered! She uses it for making budgets for the next year, and she also likes to compare the actual costs of baking things with the standard costs to see where the big differences are. That can point out areas of her business that need attention.

While actual and normal costing are best for preparing financial statements, standard costing is a great planning and management tool.

Lesson Summary

Normal costing uses actual materials and labor costs along with overhead allocated by labor hours times a budgeted overhead rate. As long as the overhead rate is good, it is an accurate costing method that is approved as a generally accepted accounting principle for financial statement preparation.

Standard costing, on the other hand, uses estimates for the materials and labor hours it should take to produce a finished product, along with the same budgeted overhead rate as in normal costing. Standard costs are a useful management tool for planning, giving price quotes to customers and comparing with actual costs to identify problem areas.

Summary:

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